Recent months have witnessed an unusual amount of speculation over when the Federal Reserve will finally begin raising interest rates. At times, it seems like this is the only issue on the minds of market prognosticators and TV’s talking heads. As shown in the chart on page 2, even the slightest hint of a possible move from the Fed can trigger a financial market reaction. Yet, looking back over the last several months, U.S. bond and stock markets have been relatively stable. The cacophony of commentary resulting in so little net change reminds us of Macbeth’s famous line: …it is a tale Told by an idiot, full of sound and fury, Signifying nothing. We don’t mean to make light of a very serious investment issue, but it seems to us that too much time is spent speculating about when the Fed will hike interest rates and not enough on the consequences of such a move and how one should think about being positioned when the inevitable happens. Rising interest rates influence the economy and financial markets in several ways—most of them negative. Borrowing costs increase, restraining corporate profits and consumer spending. Higher rates in the U.S. attract yield-hungry global funds, pushing up the dollar. That makes U.S. exports less competitive and reduces the profits of U.S. companies denominated in foreign currencies. Rising rates also have a direct, negative impact on bond prices, and they tend to constrain stock valuations. Of course, these disruptions don’t happen all at once, and how rapidly they occur depends partly on how quickly interest rates rise. In considering these factors, it’s useful to remind ourselves that an increase in interest rates from today’s exceptionally low levels simply represents a return to historical norms. From a financial perspective, we are truly in uncharted territory. The uncertainty associated with forecasting interest rates, inflation and economic growth is therefore exceptionally high. It’s hard to know how to predict outcomes when the financial world has never been in a similar position. The Fed has kept short-term rates at virtually zero since late 2008, just after the failure of Lehman Brothers. Moreover, quantitative easing—the massive purchase of bonds by the Fed, quadrupling its balance sheet to $4.5 trillion—was created and deployed to encourage the extension of credit and the purchase of risk assets, thereby stimulating economic growth and warding off the possibility of deflation at a time when confidence was extremely low. Not to be overlooked is the uncertainty associated with the change of Fed leadership from Ben Bernanke to Janet Yellen, still early in her term and establishing her communication style. It’s not clear yet exactly how she intends to put her own stamp on the central bank. Further, it’s been nine years since the Fed last raised rates, so our experience with higher rates is stale. Finally, central bank policies around the world are now on diverging paths—substantial easing in Europe, Japan and parts of the developing world in contrast to the approach of tightening in the U.S. At a time when global economies are closely linked by trade and financial markets, this divergence only adds to uncertainty. One indication of the differing perceptions (and implied risk) in today’s market climate is that, based on futures markets, investors seem to expect the Fed to raise rates at a somewhat slower pace than the Fed itself has suggested. We would remind readers that our job as investment advisors is to help clients achieve their long-term financial objectives rather than to predict economic inflection points and outcomes. We leave that to others and would note that such forecasts are typically wrong as often as they are right. On the other hand, it’s important to consider a broad spectrum of possible outcomes when formulating investment strategies for clients, so that portfolios are positioned in an effort to meet their objectives under a range of conditions. We believe it’s more productive to focus on the things we can control (positioning portfolios for various levels of risk and return, etc.) than those we cannot. Nonetheless, it is reasonable to assume that the Fed will begin to raise rates sometime in the next 12 months, barring some unforeseen setback in the economy. To the extent that markets tend to discount future events by about a year, we are probably beginning to feel the effects of such a policy change now. The question is, where will it lead and how should one be positioned? EXHIBIT 1: Federal Reserve Pronouncements Influence the Equity Market Period April 30, 2013, through April 30, 2015 SOURCE: BLOOMBERG Implications for Stocks Let’s look at some of the potential implications of a Fed move. Rising interest rates in the U.S. at a time when most other central banks are still easing would tend to suggest that the dollar will strengthen further as investors are attracted to higher yields in the U.S. Of course, there are other influences on currency values, most notably international trade, but money flows are a key factor in the short run. While U.S.-based tourists would enjoy the effect of the increased purchasing power of their dollars in international markets, a higher dollar poses at least two challenges for U.S. corporations. First, reported earnings are penalized by the effect of translating profits earned outside the U.S. (and thus denominated in foreign currencies) into increasingly expensive dollars. In the last couple of quarters, a number of U.S.-based multinational companies cited currency translation as a reason for missing their earnings projections. According to Factset, approximately 40% of the profits of the Standard & Poor’s 500 companies are earned outside the U.S., so the impact of a higher dollar on large-cap companies could remain meaningful. The second challenge is that a stronger dollar makes U.S. goods and services less competitive in world markets. While more subtle and harder to quantify, this factor could pose a modest hurdle for U.S. corporate profits. But since exports make up only about 12.5% of U.S. GDP, according to the Bureau of Economic Analysis, the impact of a rising dollar in the U.S. is likely to be relatively small. On the positive side, the decline in energy prices is beginning to boost the profits of those companies that rely on petroleumbased raw materials or that count energy as a major expense. At some point, too, consumers should start to spend their energy “dividend” from declining oil and gas prices, although so far there is little evidence in the retail sector that this is happening. Fed policy makers have made it clear that they will not raise interest rates until the U.S. economy is stable and even strengthening. Although the Fed’s ability to forecast is subject to many of the same risks as that of other observers, we are confident that the central bank will stand by that commitment. The consequences of acting prematurely and pushing the economy back into recession are simply too grave. The Fed is on record saying it would raise rates when it is “reasonably confident” that inflation is likely to reach 2% over the medium term. That implies a pick-up in growth above the sluggish rate of the last two quarters and perhaps enough to help corporate profits overcome the effects of a stronger dollar. EXHIBIT 2: Equity Returns Generally Positive Before Rate Hikes SOURCE: BLOOMBERG Returns shown are for the Standard & Poor’s 500 Index during the periods shown. On balance, then, we think earnings can expand over the next couple of years, headwinds notwithstanding. The rate of growth, however, is unlikely to equal the robust pace of recent years. Considering that equity valuations have risen meaningfully and are now well above their historical averages, it seems logical to conclude that stocks have seen their best gains of the cycle and will probably encounter some turbulence in the months ahead. It’s worth noting, however, that stocks tend to rise in the months leading up to a Fed tightening cycle and then (with the exception of the 1987 crash) do not decline rapidly after the first rate hike, as shown in the above chart. The maturing profit cycle in the U.S. has led us to reduce what had been a long-standing recommendation to overweight U.S. equities. Conversely, we are increasing weightings to international equities in both developed and emerging markets. Over the last five years (through May), the U.S. stock market has gained about 16% annually while the MSCI All-Country World Index (ex- U.S.), a good measure of international equities, has returned about 8% per year. This difference in performance, combined with the recent pick-up in foreign economies, suggests that portfolios should be more evenly balanced between U.S. and non-U.S. stocks. Bonds: Still Investable? In an environment of rising interest rates, bond strategies need to be adjusted. Conventionally, bonds are a source of income and stability in portfolios, but in today’s market, yields are low and prices can be volatile. Adding to the volatility is the unusual volume of corporate bond issuance to take advantage of today’s low rates. On the plus side, default rates are only a minor factor because of the gradually improving economy. Further, leverage in the corporate and consumer sectors has declined because of greater caution on the part of borrowers and tighter regulation of financial institutions in the wake of the financial crisis. There are also several “institutional” reasons why demand for bonds will continue despite the probability of higher rates: Bonds, particularly U.S. government issues, are held by many institutions such as banks, insurance companies and pension funds as collateral or to match assets with liabilities. Central banks around the world hold U.S. government bonds as reserves because of their perceived quality and ready liquidity Quantitative easing (the massive purchase of bonds) in Europe and other regions means that demand for bonds outside the U.S. remains strong, helping to keep interest rates abroad artificially low. The linkage of the U.S. to foreign markets leads to a spillover into U.S. bond markets. When rates do begin to rise, it seems unlikely that they will accelerate to the levels that historically have marked a cyclical peak—typically 6% or more for 10-year U.S. Treasury bonds. GDP growth is still somewhat tentative even after seven years of recovery following the financial crisis and a large drop in unemployment. Unless the pace of economic activity picks up dramatically, the Fed presumably will be reluctant to raise rates aggressively lest it risk inducing another recession just as confidence is returning. Another reason the Fed would act cautiously stems from the evolving regulatory environment. The financial crisis came as a kind of wake-up call for regulators when taxpayers ended up footing the bill for most of the loan losses during that period. Those losses resulted primarily from the extension of credit to marginal borrowers during the boom period that preceded the crisis. In order to prevent the recurrence of such a politically unpalatable outcome, regulatory emphasis has shifted to prevent loan losses from occurring in the first place by limiting less credit-worthy borrowers’ access to loans. Theoretically at least, the new approach has the effect of restraining peak economic expansion, suggesting that 4+% growth in GDP may be difficult to achieve. If so, interest rates (which generally reflect trends in growth and inflation) are unlikely to reach the highs typical of previous cyclical peaks. It would appear, then, that the rise in interest rates over the coming cycle will be more muted than is typically the case. Also worth noting is that in a period of Fed tightening, short-term rates are likely to increase more than long-term ones. This is because monetary policy operates primarily at the short end of the yield curve, and short rates are currently as low as they can go without being negative. Thus, the yield curve will probably flatten a bit as the Fed raises rates. In such an environment, investors who keep their maturities relatively short should be able to turn over (i.e., reinvest) their portfolios as bonds mature, thereby taking advantage of rising short-to-intermediate-term yields as they occur. At the same time, as we’ve said, yields on longer-dated maturities are unlikely to rise dramatically for the reasons cited above and assuming that inflation is kept largely at bay in the intermediate term. As a result, we have maintained a “barbell” strategy, tending to emphasize the short and long ends of the yield curve while underweighting the intermediate maturities that yield little but have exposure to the negative impact of rising rates. Cautionary Notes Any discussion of bonds must, however, take into account the long-term risks associated with today’s extraordinarily low interest rates coupled with the likelihood of higher inflation at some point. As we’ve already mentioned, the financial crisis caused central banks around the world to implement aggressive monetary easing over an exceptionally long period of time—almost seven years now—in order to stave off what they perceived as a risk of deflation. In several cases, this involved the direct purchase of bonds by central banks. The resulting dramatic expansion of central bank balance sheets over this period has meant that the total burden of debt (public and private combined) around the world has increased considerably. The rise in aggregate debt has been manageable because of artificially low interest rates brought about by the concerted easing, but if inflation again becomes a reality, rates will inevitably rise, creating significant economic drag. In addition to today’s heavy debt load, it’s important to recognize the enormous growth of entitlements, which are in essence another form of debt. In the U.S. and other developed countries, entitlements are mostly in the form of retirement and health care plans, both of which continue to rise relentlessly as the proverbial can is kicked down the road by politicians generally unwilling to confront this harsh reality. Perhaps the most egregious example of these obligations is the state of Illinois, which now has an estimated $110 billion in unfunded pension liabilities. A 2013 pension reform law designed to help alleviate the crisis has been struck down as unconstitutional in the state Supreme Court, which ruled that pension obligations are contractual and cannot be “diminished or repaired.” The state has little choice but to increase taxes at a time when businesses and people may leave for less heavily taxed locations. Faced with mounting debt loads and entitlement obligations, central governments have a strong incentive to inflate their currencies so that these obligations can, over time, be funded with devalued dollars, euros or other denominations. That is, in effect, what most countries are attempting to do through monetary easing. Only time will tell when inflation will pick up around the world, but at some point it is inevitable. In the meantime, investors should be wary of long-term bonds carrying low coupons. In a period of just eight weeks this spring, for example, the yield on the German 10-year note rose from almost zero to about 1.0%. Such a move resulted in a loss of principal value of more than 7%. Even at 1.0%, the yield is lower than the likely 10-year rate of inflation in Germany (inflation is currently projected to be 0.45% for the next five years, but that seems optimistic). Another example of the potential pitfalls of owning long-term bonds is Mexico’s recent sale of about $1.6 billion of a 100-year bond denominated in euros with a 4.2% yield to maturity. Over such a long period of time it’s anybody’s guess what inflation will be and what the relationship will be between the peso and the euro. The risks of holding longer-dated bonds can be significant. Quality bonds with a 25- to 30-year maturity, for example, typically sell at a substantial (in some cases 40% to 50%) premium to par, or their original issue price, because interest rates are depressed. If yields were to rise, the price would decline materially. As we’ve pointed out, however, we think that the yield curve is likely to flatten as rates rise, making the longer-term bonds less vulnerable to price erosion than intermediate ones— hence our barbell strategy. And, of course, it’s possible that interest rates will decline from current levels, resulting in a profit opportunity for the bond holder. The likelihood of an extended decline seems remote, however, since rates are still near historical lows. We own a number of long-term bonds for clients for reasons of yield and portfolio balance, but it’s unlikely that we will hold them to maturity (in contrast to unmanaged “laddered” portfolios). Instead, we actively manage a portfolio over time to adjust to changing conditions while being cognizant of the likelihood of higher inflation over time. In effect, the inflation that central banks have been trying to induce has gone largely into financial assets rather than the “real” economy—labor and materials costs. At some point, “normalcy” will return and the current excess supply of money will find expression in accelerating inflation. While we cannot predict when this will happen, we do know that rate-sensitive assets will suffer. All the more reason to maintain balance in portfolios amid the sound and fury. The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance. In addition, these views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients or other clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients and is for informational purposes only. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. An investor cannot invest directly in an index. The S&P 500 Index represents the large-cap segment of the U.S. equity markets and consists of approximately 500 leading companies in leading industries of the U.S. economy. Criteria evaluated include market capitalization, financial viability, liquidity, public float, sector representation and corporate structure. An index constituent must also be considered a U.S. company. The MSCI All Country World Index Ex-U.S. is a market-capitalization-weighted index maintained by Morgan Stanley Capital International (MSCI) and designed to provide a broad measure of stock performance throughout the world, with the exception of U.S.-based companies. The MSCI All Country World Index Ex-U.S. includes both developed and emerging markets. The NASDAQ Composite Index measures all NASDAQ domestic and internationa-based common type stocks listed on The NASDAQ Stock Market. Launched in 1971, the NASDAQ Composite Index is a broad-based Index. Today, the Index includes over 3,000 securities, more than most other stock market indices. The NASDAQ Composite is calculated under a market-capitalization-weighted methodology index.